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Many contract-based businesses face challenges fulfilling their contracts due to the high upfront costs of starting a project and a payment cycle that usually pays for work only after it’s completed. In addition, many banks consider lending to contractors too risky. These factors combined can cause contractor businesses to pass up jobs. Smaller contracting companies, subcontractors and women- and minority-owned contracting businesses are especially susceptible to this fate.
If you’re struggling with cash flow and qualifying for a small-business loan, contractor financing can be an effective way of fulfilling contracts and growing your business.
What is contractor financing?
The term “contractor” usually refers to a general contractor or subcontractor; however, it can refer to anyone whose business model is dependent on contracts with a local or federal government, or with a larger, private corporation. Contractor financing, or contractor mobilization lending, is a specialized form of financing that relies on the value of a contract — rather than business profit — to underwrite a loan.
Contractor financing can also more broadly refer to small-business term loans, equipment loans or lines of credit that are given to contractors. Because many banks won’t lend to contractors, lenders that advertise contractor financing may simply mean that their loan products are open to contractors.
How does contractor financing work?
Rather than using the traditional components of loan underwriting like personal credit, business profit or collateral, contractor financing relies on the value of a contract that has been won by the business to underwrite a loan. Similar to invoice financing or accounts receivable financing, the contract acts as a form of collateral that a lender can use to ensure repayment.
Contract loans are usually short-term — some lasting only as long as the expected timeline of the contract. Their uses are typically limited to contract-related expenses and the repayment terms are structured to align with the contract’s payment terms. The loan amount is typically anywhere from 20%-30% of the total value of the contract.
Contractor loans may be lender-controlled or borrower-controlled. For lender-controlled loans, your lender sets up a separate account and collects money directly from the entity awarding the contract. This allows it to track payments from your client to ensure it gets paid first. A borrower-controlled loan is just the opposite, and repayment functions more like a traditional loan. You are in control of the payments you receive and responsible for making payments to the lender.
When to use contract financing
When you’re looking to scale your business. Seeking larger contracts can ultimately help your business grow but can also result in cash-flow gaps. Using contractor financing to start winning bigger contracts can be an effective growth strategy.
When you can’t qualify for a traditional loan. Because contractor loans rely less on business profit and personal assets, they can be a good option if you’re having trouble qualifying for traditional lending.
When you don’t have financing needs outside of your contract. Because contractor loans are underwritten to a specific contract, their uses are normally limited to that contract. If you have other business financing needs, you may be better off going for a traditional term loan or a line of credit.
When you don’t have large assets to use as collateral. Because your contract acts as collateral, contractor loans don’t require other assets to collateralize.
If you have a good relationship with your client. Contractor loans work especially well if you trust the client you’re working with. That will not only make the application process easier, it may also demonstrate to the lender that there won’t be any problems with repayment.
What you’ll need to qualify
Ultimately it will depend on the individual lender, but you can generally expect to prepare the following to qualify for a contractor loan:
Proof of awarded contract. Your lender will need to see the terms of the awarded contract so it can do its own research and understand how it can structure the loan to align with the contract.
Business history. Though it's not weighted as heavily for contractor loans, lenders will still likely want to look at your business’s financial history. They may also request references or proof of previously completed projects.
Contact information for the entity awarding the contract. Especially if your loan is lender-controlled, your lender will want to have a way to contact your client directly. It may want to ask questions about the contract and payment.
Alternatives to contractor financing
In addition to contractor mobilization loans, there are other ways to finance a contract or contract-based business:
Invoice financing or accounts receivable financing functions similarly to a contractor loan in that your loan amount is secured against unpaid invoices you have coming in. Like contractor financing, it can be effective at filling gaps in cash flow. This type of financing may be better suited for smaller contract-based businesses.
Small-business term loans
Though many turn to contractor loans because they’re having trouble getting traditional term loans, it’s worth checking if you can qualify for term loans first, especially if you have financing needs that extend past one contract. Term loans may also be cheaper in the long run and can help boost your business credit.
SBA 504 loans and 7(a) loans support construction lending and can be a great option if you’re having trouble qualifying through traditional lenders, especially if you’re a smaller company. SBA loans are underwritten by accredited Small Business Administration lenders, so you may be subject to their qualification requirements.
Business lines of credit
Business lines of credit, including business credit cards, can be a great alternative to a short-term contractor loan because they are revolving and can continuously fill cash-flow gaps on multiple contracts. However, if you don’t stay on top of paying down the line of credit, you may run out of hit your limit, and interest can add up quickly.